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Financial Literacy, Risk Aversion and Choice of Mortgage Type by Households

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This paper analyzes how financial literacy and reported willingness to take financial risk impact a household’s choice of mortgage type. The results show that households reporting higher financial literacy and lower risk aversion are 55 to 97 % more likely to opt for interest-only mortgages. The results are robust to alternative explanations such as the involvement of financial advisors, the effect of peers, experience with prior home-ownership, and house price expectations. In general, alternative mortgage products, as opposed to traditional mortgages, are chosen by wealthier, older, and/or more sophisticated households that are more likely to have a greater understanding of the risks and benefits associated with these products.

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  1. Recourse debt holds households liable for complete repayment of their mortgage in case a foreclosure occurs and proceeds fall short of the outstanding balance. Strategic default is therefore never a valuable option as the costs always exceed the benefits.

  2. The intuition behind this result is that the interest-rates on FRM contracts incorporate a term premium and are therefore less appealing to households who are currently borrowing-constrained or are more likely to move in the near future. Since they are generally younger, they are expected to choose ARM mortgages ceteris paribus, to take advantage of the lower initial interest rate.

  3. See for a more elaborate discussion Schober and Conrad (1997).

  4. The number of observations per quartile is not equal to 25 % of the total because household wealth and the corresponding quartile are computed year by year allowing for the possibility of transition to another wealth quartile.

  5. Unlike for example the U.S., origination fees in the form of points are non-existent in the Netherlands. Upon origination, lenders and intermediaries receive compensation through provisions which are calculated as a percentage of the initial balance. Inclusion of the interest rate and the size of the balance in our analyses ensures that effects due to pricing differentials are taken into account.

  6. The increase in average household income is taken into account. Average income amounted to €32.500 in 2009, compared to only €21.780 in 1994. Low income is defined as households with an annual reported income below national average. Medium incomes are defined as households with an average up to twice the average income, and high-income are those households whose income exceeds twice the average income.

  7. Financial advisors are often paid on commission base and might impact the decision process according to the incentives provided to them (Inderst and Ottaviani 2009) rather than truthful and honest information disclosure. In additional analysis, we find no bivariate dependence between advisor involvement and contract choice.

  8. Negative amortization contracts and ‘subprime’ mortgages (e.g. 2/28 ARM’s) are not available in the Netherlands.

  9. We have chosen an endowment mortgage as an example of a deferred amortization-type. Life-annuity and investment mortgages work in a similar way.

  10. Fixed term agreement for long term call option on existing securities, which is an option or warrant on an existing security with an extended maturity.


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The authors want to thank the editor James Kau, two anonymous referees, Dion Bongaerts, Eric Duca, Andra Ghent, Melissa Porras Prado, Avichai Snir, Manuel Vasconcelos, Vincent Yao and seminar participants at the Rotterdam School of Management, the AREUEA Mid-Year Meeting (2011), the Understanding Societty Meeting (2011) and the Third ReCAPNet Conference (2011) for valuable comments. We thank the National Mortgage Guarantee (Stichting Waarborgfonds Eigen Woning) for financial support. All remaining errors are ours.

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Correspondence to Ruben Cox.

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The views and opinions expressed in this paper are solely the author’s and do not reflect the official view, policy or position of the AFM, its Board of Directors, or any other Dutch government agency.



Mortgage products in the Netherlands

This appendix discusses the differences between available mortgage types in the Netherlands in detail as well as the distribution of origination over time. Mortgage interest payments are fully deductible at the marginal income tax-rate (typically 42 or 52 %), but amortization payments are not a tax-deductible item. Maximization of tax-benefits therefore requires that any amortization charges are not directly deducted from the outstanding principal as this lowers the deductibility of interest-rate payments as well. The two mortgage categories that cater to this tax-arrangement are deferred amortization – where a household saves in a separate account for a balloon payment at maturity – and interest-only products, were no amortization payments prior to maturity are made.Footnote 8 Although hybrid mortgages are available in the Netherlands (e.g., a combination of an annuity and endowment mortgage), they constituted only a minor part of the sample (less than 5 %) and they are classified here as one type based on the size of the principal of the individual mortgage relative to total outstanding mortgage debt. Our classification of the different available contracts in the dataset is shown in Table 10.

Table 10 Mortgage types in the Netherlands based on DNB Household Survey

To illustrate how the affordability and amortization develops, we compare after-tax payments in year one and after 15 years for three different mortgage types in Table 11.Footnote 9 A traditional amortizing annuity contract immediately starts repaying, and this amortization constitutes an increasing proportion of the total mortgage expenses. The outstanding balance decreases steadily until the mortgage is completely paid off at maturity. Consequently, the tax-benefit of interest payments decreases as they fall in tandem with the lowered outstanding principal, while amortization payments are not tax-deductible.

Table 11 Payment schedule for different mortgage types

In the case of an AMP the repayment of the principal is deferred towards the future. The example in the table assumes an endowment mortgage. Instead of directly subtracting the amortization-payments from the principal, the repayment of the principal is converted to an annuity and the endowment payment goes into an endowment fund. In this case the 200,000 euro liability due after 30 years is annuitized, assuming that the endowment-fund will yield an average return of 6 % over the term, with the yearly endowment in this case amounting to 2,530 euro, which is lower than the 3,278 euro amortization payment on an annuity-mortgage. As the outstanding balance is not repaid, the benefits of tax-deduction are not decreasing, but instead the mortgage is paid off at maturity with the proceeds of the endowment fund. Finally, the interest-only mortgage – as implied by its name – only features interest-expenses until maturity. At maturity the proceeds of a sale of the collateral, private savings, or a refinancing of the mortgage, should suffice to pay off the principal. Again, this construction maximizes the benefits of tax-deductibility. It can also be seen that the net-yearly charges in year one are highest for traditional amortizing contracts (8,498 euros), followed by endowment (7,750 euros) and interest-only mortgages (5,220 euros), hence the name ‘affordability’ mortgages.

The downside of the affordability is the increased repayment risk of AMP’s, assuming that households are able to honor their obligations till maturity. If the return on the endowment fund is lower than the anticipated 6 %, the terminal value of the fund will be insufficient to repay the mortgage at maturity (i.e. a 5.5 % return will lead to a shortfall of more than 16,000 euro at maturity). For interest-only mortgages the risk is – all else equal– even higher as the borrower is dependent on the value development of his property until maturity or his personal wealth.

Figure 1 plots the distribution of newly originated mortgages between 1994 and 2009. There is a substitution effect in newly originated mortgage types from traditional mortgages towards interest-only contracts similar to patterns observed in the U.K. The share of interest-only contracts in the total product mix rose from 3 % in 1994 to 45 % by 2009. This massive increase in popularity is primarily driven by the aforementioned tax-regime, rising house prices and low interest rates, as the demographic characteristics of new borrowers remained constant during the same period.

Fig. 1
figure 1

Development of mortgage types and market shares in the total Dutch mortgage portfolio between 1994 and 2009. Source: DNB Household Survey

Measurement of Risk Aversion and Financial Literacy

For the analysis of the impact of financial literacy, risk aversion, and opinions about the current and future situation on mortgage choice, several questions from the DNB Household Survey were used. The exact wording of these questions is presented here.

Risk Aversion measures

All questions could be answered on a seven-point scale ranging from 1, totally disagree with the statement to 7, totally agree.

The resultant scale was constructed by recoding the responses on risk aversion measures 3, 5, and 6 and adding them up together, thereby creating one scale that can range from 6 (very risk tolerant) to 42 (very risk averse). Analysis of the scale using the Cronbach Alpha measure shows that the scale could not be improved by deleting items and the coefficient of 0.927 exceeds the 0.90 level that Nunnally (1978) suggested as a threshold for scales used in decision-making processes.

Financial Literacy measures

Self-reported financial knowledge

Respondents were asked to respond to the following statement:

“How knowledgeable do you consider yourself with respect to financial matters?”

With response categories:

  1. 1.

    Not knowledgeable

  2. 2.

    More or less knowledgeable

  3. 3.


  4. 4.

    Very knowledgeable

Financial active

Financial activity is measured using the following seven questions:

  1. 1.

    “Did you, on 31 December [year], have investments with MUTUAL FUNDS? Do not include investments in growth funds, investments (shares, bonds) in companies, or insured saving (i.e., saving through a life-insurance) here.”

  2. 2.

    “Did you, on 31 December [year], have any BONDS and/or MORTGAGE BONDS? Do not include bonds through mutual funds here. These have already been reported on.”

  3. 3.

    “Did you, on 31 December [year], own any SHARES? Do not include shares of your own private limited company here, nor bonds through MUTUAL FUNDS. These have already been reported.”

  4. 4.

    “Did you, on 31 December [year], have one or more PUT-OPTIONS?”

  5. 5.

    “Did you have any written PUT-OPTIONS outstanding on 31 December [year]?”

  6. 6.

    “Had you, on 31 December [year], bought one or more CALL-OPTIONS, FALCONS, or WARRANTS?”

  7. 7.

    “Did you have any written CALL-OPTIONS, FALCONSFootnote 10 or WARRANTS outstanding on 31 December [year]?”

Responses are recorded as a dummy variable equaling 0 (= no) if the household did not hold the security at 31 December and 1 (= yes) if the household did hold the security. Final scores were obtained by counting the total number of yes-responses, resulting in a scale that ranges between 0 and 7, where 0 indicates that the household does not hold financial assets at all, while 7 indicates that the household holds all mentioned securities.

  1. Risk Aversion 1:

    “I think it is more important to have safe investments and guaranteed returns, than to take a risk to have a chance to get the highest possible returns”

  2. Risk Aversion 2:

    “I would never consider investments in shares because I find this too risky”

  3. Risk Aversion 3:

    “If I think an investment will be profitable, I am prepared to borrow money to make this investment”

  4. Risk Aversion 4:

    “I want to be certain that my investments are safe”

  5. Risk Aversion 5:

    “I get more and more convinced that I should take greater financial risks to improve my financial position”

  6. Risk Aversion 6:

    “I am prepared to take the risk to lose money, when there is also a chance to gain money”

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Cox, R., Brounen, D. & Neuteboom, P. Financial Literacy, Risk Aversion and Choice of Mortgage Type by Households. J Real Estate Finan Econ 50, 74–112 (2015).

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